At this point, the evidence is close to overwhelming that the Federal Reserve will embark on a tightening cycle this year. The base case for markets should be a move in September. While the pace of tightening should be very shallow and the ultimate destination for interest rates considerably lower than historical experience, investors should not underestimate the potential volatility emanating from the first interest rate increase in nine years and the first move off of the zero bound in six years.
Looking at recent data, Friday’s payroll report showing 280,000 jobs were created in the U.S. last month was not only stronger than expected, but net revisions added 32,000 jobs to the previous two months’ reports, further demonstrating the improvement in labor markets. As Rich Clarida explained in a previous post (read here), the Fed is looking for solid momentum in the job market and assurances that weak GDP in Q1 was a fluke.
First quarter U.S. growth was certainly weak, but as we progress further into the second quarter, the evidence mounts that the slowdown was largely related to weather, ports, currency and seasonal trends as opposed to a more concerning broader slowdown in the expansion.
Given the sustainability of the expansion, the Fed should have the confidence to embark on a modest tightening cycle. Any argument that the economic expansion is too tepid to withstand slightly higher interest rates seems increasingly off. Can one really argue that the U.S. economy will collapse under the burden of 0.5% to 1.0% short-term borrowing costs?
Financial conditions may contract following the first rate increase, with the dollar strengthening, interest rates moving gently higher, the yield curve flattening and the stock market taking a pause or correcting, but this should be manageable given underlying economic strength. Meanwhile, elsewhere around the globe, zero and negative interest rate policies remain in place – eurozone, Switzerland, Japan.
Rest in peace, zero interest rates. Rest in peace.